Exempting end-users -- or not

Quick refresher: A derivative end-user is someone -- usually a company -- who uses a derivative hedge against real risks. United Airlines hedging against a sudden spike in the price of oil, for instance. And these folks have been working very, very hard to exempt themselves from the regulations around derivatives.

But reading this piece from the perspective of a derivative end-user is a reminder of at least two reasons to be very careful with those exemptions. First, a lot of large corporations use derivatives to juice profits through, well, trading derivatives. They're not hedging risks so much as running an internal hedge fund. Cargill, for instance, is known for doing this. And if they suddenly have free rein over the unregulated derivatives market, their hedge fund business will get bigger, and riskier. That's not an incentive we necessarily want in the system. It's one thing to have to bail out an investment bank that got into risky trading. It's a whole other level of absurdity to bail out a hamburger producer.

It's also the case that a lot of corporations don't want to bring their derivatives use into the light because it wouldn't look that good. Derivatives can be used to make balance sheets look better, to ease strains before a quarterly report, and generally to do all sorts of other chicanery. That's obviously delicate work, and so those corporations like having a one-on-one relationship with a bank that understands their situation and is used to helping them do what they need to do. That's part of why they're willing to pay the higher fees required for customized derivatives rather than going to a more transparent system where they wouldn't be paying such high fees.

Now, there obviously are many cases where companies user derivatives fully legitimately. But most of what they do can be done on a transparent, standardized market. Which is why I'd still like to see the end-user exemption removed from the bill altogether and replaced with an option to petition the head of the SEC for an exemption, which would limit the exemptions to pretty clear cases where the corporations thought their activities would stand up to scrutiny.

a tax on derivative transactions would help to put the brakes on extra trading. Trading derivatives on an open exchange so that all players can see what is being traded for how much money would eliminate the problem of internal hedge funds operating inside commodity companies. I can't believe the wisdom of the markets people don't immediately sign up for a nice open market where market forces can actually work.

Could you explain in more detail why these end-users feel that they shouldn't have to be part of a regulated derivatives market?

As I understand it, this wouldn't prevent them from doing something like hedging against an oil spike, but just make them do it in a way that's transparent and regulated. Why would they be opposed to that?

If the end-users are doing totally legit stuff, then they don't need to hide their activities!

Simple.

Also, these folks are probably cutting off their own noses. They'd probably get better deals (pricing) with increased transparency. They probably don't know what their brokers are taking off the top, and the brokers are really, really rich. So, I expect it's a good deal.

what about an improved accounting standards board? the point of accounting is to make financial statements as clear as possible and the point of public accountants is to enforce accounting rules. weak rules = weak financial statements. I think that sort of legislation would scare companies the most.

Kind of an evidence-free post here, Ezra. Please, for example, provide some evidence for this: "obviously are many cases where companies user derivatives fully legitimately. But most of what they do can be done on a transparent, standardized market." "Most"? How do you know that?

And for that matter, since you're such an expert on the subject that you can make these generalizations, why don't you take a couple of specific examples -- say, a fertilizer factory in Nebraska, natural gas; and a refinery in Montana, oil -- and explain the costs and benefits of their hedging their risks using exchange-traded products?

We are already have a pretty substantial process for hedging risk called "insurance." The insurance model for commercial risks does not involve trading of generic instruments on an open clearinghouse -- it involves creation of bespoke contracts that fit risks specific to the user and that the insurer agrees to take on. Since end-user use of derivatives is more like insurance than it is like stocks and bonds, it's not at all clear what good comes out of forcing those contracts onto an exchange. The key issue should be the safety and soundness of those issuing the derivatives, not how the users end up buying the contracts.